Egypt: Time to entrench growth and make it more inclusive

Egypt’s economy is recovering, supported by prudent macroeconomic policies and initial bold reforms aimed at addressing the major challenges that have confronted the economy in recent years. The task now is to deepen reforms to raise economic growth further, make it last, and spread its benefits to Egypt’s rapidly growing population and its youth and women, the IMF says in its latest economic health check.

After more than a year since the launch of the economic reform program, GDP growth is strengthening and inflation is declining. The government trimmed the budget deficit, tourism revenues and remittances are increasing, and the country’s foreign exchange reserves have been rebuilt. The floating of the pound and the initial steps to improve the business climate have helped boost growth. 

“This macroeconomic turnaround at home and the supportive global economic environment provide a unique opportunity to carry the reform momentum into areas that have historically been hard to tackle. Deep and lasting structural reforms are needed to create jobs as speedily as needed for Egypt’s growing population,” said Subir Lall, head of the IMF team for Egypt. 

Below are the IMF’s key recommendations.  

Making stability last 

Egypt must entrench the stability attained thus far. This entails preserving the flexibility of the exchange rate and further reducing inflation. The government should also continue to lower the budget deficit to contain public debt. For this purpose, the IMF suggests:

• Collecting more revenue to pay for much-needed social services and to invest in education, health, and infrastructure. Reducing tax exemptions, making the tax system more progressive (richer people pay progressively more in taxes), and making tax administration more efficient will facilitate this process. Revenue could grow by 4 percent of GDP in the medium term as a result, analysis in the report suggests.

• Eliminating most fuel subsidies, which benefit mainly the rich, and allowing fuel prices to change in line with costs: This would protect the budget from movements in global oil prices and the exchange rate, and safeguard priority spending on social programs and necessary infrastructure.

Helping low-income families 

Although economic stabilization is critical, Egypt also needs to protect its lower-income families. This requires continuously improving the efficiency of social assistance by reducing price subsidies and expanding better-targeted cash transfer programs such as Takaful and Karama to free up resources for those who need them most, while avoiding the buildup of unsustainable public debt. 

Letting the private sector flourish 

Egypt’s growing population needs about 700,000 new jobs every year, which is possible only if the private sector becomes the main engine of growth. For that to happen, the state – which has a prominent role in the Egyptian economy – needs to step back from certain sectors and make room for the private sector to invest and grow. 

To this end, priorities include ensuring fair competition for private companies in the markets for their inputs and products, improving the governance and transparency of state-owned enterprises, reducing the perception of corruption, improving access to financing and land, and integrating more women and youth into the labor market. 

Context

Egypt launched a reform program when its economy faced rising imbalances that led to weakening growth, high public debt, a widening current account deficit, and declining official reserves. To support the homegrown reforms, in November 2016 the government initiated an IMF-supported arrangement to restore the stability of the country’s finances and promote growth and employment, while shielding lower-income households from the adverse effects of the changes. On December 20, 2017, the IMF Executive Board approved the third installment of the three-year, $12 billion Extended Fund Facility.

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Selected Issues paper

Unlocking higher and more inclusive growth

Like some other emerging market economies, Egypt faces the challenge of raising growth and creating more jobs to improve the living standards of its young and growing population. The analysis in this paper shows that past growth was characterized by a suboptimal allocation of the factors of production and a lack of dynamism in the private sector. By identifying the main constraints to private sector-led growth and higher employment generation, it suggests policies to further shift Egypt’s economic model towards increased private sector participation and integration into global value chains.

To this end, reforms should aim at removing the distortions to the optimal allocation of resources in the economy and equip the labor force with the skills needed to benefit fully from future job opportunities. These reforms would also help better integrate women and youth into the job market. The authorities have embarked on a reform program to address these challenges and important steps have already been taken. Improved macro-stability and a strong political commitment to reforms present an opportunity to further structural reforms that intensify private sector-led growth and job creation and strengthen trade integration.

Growth, Private Sector, and Labor Market Diagnostic

Growth in Egypt in past decades has been characterized by an inefficient use of production factors. Per capita growth decomposition3 shows that capital deepening (measured by the capital- labor ratio) was the main driver of GDP growth over the last two decades. It explained about 80 percent of total real per capita GDP growth during the 1990s and 2000s. However, the high contribution of capital to growth was not explained by high investment. The investment-to-GDP ratio has been stable around 15 percent over the last 15 years, lower than in EM Middle East, North Africa, Afghanistan, and Pakistan (MENAP) and in other EMs at 26 and 33 percent respectively over the same period. In addition, over most of the period, it was not associated with total factor productivity (TFP) gains, suggesting that investment was not efficiently allocated to improve within-sector productivity or contribute to structural change through a reallocation towards more productive industries. In fact, TFP contribution to growth became negative during the 2000s, contrasting with EM peers where TFP gains were a major source of growth. The lack of competitiveness of the Egyptian economy was also reflected in the negative contribution of the external sector to growth over the last few years. At the same time, labor utilization contribution to per capita growth, measured as the change in the employment-to-population ratio, was close to 0 during the 1990s and 2000s. It contributed negatively to per capita growth over 2011-14 (-2.5 percent) highlighting that Egypt was not able to absorb its growing population into employment.

The private sector in Egypt has been less dynamic than in peer countries. Egypt’s private sector is relatively small compared to other EMs. Firms’ entry density (as measured by the number of newly registered limited liability firms per 10,000 working-age people) has been low. Based on World Bank (2015), it was about 1 against 24 on average across other countries. Associated with relatively low exit rates, Egypt’s firms’ turnover has been low compared to peers in the past.

Private sector investment is below peers and innovation and use of technology are limited. Private investment to GDP ratio was 11.4 percent over 2000-16, close to 7 percentage points below other EMs. Egypt had benefited from strong FDI inflows during the 2000s. Net foreign direct investment (FDI) amounted to 4.3 percent of GDP annually on average over 2000-10 above other EMs (1.6 percent for EM MENAP and 2.9 percent for other EMs). However, this declined to 2.3 percent on average over 2014-17. Additionally, FDI inflows were mostly concentrated in real estate and extractive industries (75 percent of total FDI), which limited positive spillovers to the overall economy. Egypt scores less well than peers on the Global Competitiveness Index for business sophistication, innovation and technological readiness, below EM peers in MENAP and outside the region. According to the 2016 World Bank enterprises’ survey (WBES), less than 15 percent of Egyptian firms had been engaged in innovations to products or processes during the three years preceding the survey. Only 6 percent of firms declared having engaged in formal Research & Development in the previous fiscal year.

Few Egyptian firms export. Only about 5 percent of Egyptian firms are exporters (EBRD, 2017). Total exports of goods and services to GDP ratio averaged 15 percent since 2000 against 42 percent in MENAP EMs and 27 percent in other EMs. Manufacturing exports account for about 53 percent of total goods exports in 2015 against 38 percent in 2000. However, according to the African Development Bank (2012), Egypt’s manufacturing exports are less sophisticated than those of EM peers and they remain concentrated in a few products. Services exports are dominated by tourism which has been severely affected in the last few years.

Egypt’s economic model hasn’t generated enough jobs. The employment elasticity of growth is relatively low. Activity has been concentrated in capital rather than labor intensive industries. Young firms appear to be more dynamic and create more jobs but they face constraints to expansion and remain small. Seventy percent of private non-agricultural employment is concentrated in micro, small and medium enterprises according to Al-Madhi and Nawar (2014). The sectors that have generated most jobs, such as retail trade, construction and transportation have mostly done so in the informal sector. In many cases, these jobs have been characterized by low quality and low productivity.

Constraints to Higher Private Sector-led Growth

While the build-up of macro-economic imbalances constrained growth in the period following the Arab Spring, the previous section suggests that growth has more broadly been limited by persistent structural constraints. This section identifies factors that have constrained the role of the private sector in the economy in the past. These include difficulties to start and exit a business, lack of competition in several key sectors, perceptions of corruption, constrained access to finance and land, lengthy customs procedures and non-tariff barriers, skill mismatches and labor market segmentation, and macroeconomic instability. The section that follows highlights that some of these constraints are currently being addressed by the authorities’ reform program.

In past decades, difficulties to start a business and a rigid exit framework have limited the emergence of young dynamic firms. The time and cost of starting a business are cited regularly as a top constraint for investors. At the most recent Egypt Euromoney conference, 50 percent of polled participants identified bureaucratic barriers to starting a business as the main constraint to foster a start-up culture in Egypt. However, based on the latest Doing Business survey, Egypt has shown progress and now performs better than other EMs. The insolvency regime in Egypt is also constraining and might deter investment and entrepreneurship. According to the Doing Business indicator, the cost of resolving insolvency is high compared to other EMs. Burdensome regulations have constrained firms’ activity and development but progress to streamline processes has been seen more recently. Based on the 2016 WBES, it takes about 32 days to obtain an operating license, down from 70 days in the 2013 WBES and 56 days to obtain a construction-related permit down from 90 days in 2013.

The lack of competition has distorted the allocation of factors in the economy. Several sectors remain protected and dominated by the public sector or a few politically connected private sector firms. The public sector is particularly involved in extractive industries, manufacturing and the financial sector. Based on official national account statistics, it accounts for 30 percent of total GDP. Even during the period of liberalization in the 2000s, several sectors remained closed to foreign investment, including aviation, engineering services, certain activities in the energy sector, steel, aluminum production, construction, insurance and fertilizers. This has generated a concentration of markets among a few players that are insulated from competition. The lack of competition has reduced firms’ efficiency and limited the emergence of new more productive firms, reducing productivity, growth and job creation. For example, using data for the period 1996-2006, Schiffbauer and others (2015) estimate that the entry of connected firms into previously unconnected sectors was associated with a significant decline in the aggregate employment generation of the sector over the period of study.

The public sector and connected private firms have also tended to benefit disproportionately from governments’ subsidies. Some government entities enjoy benefits that put private sector competitors at disadvantage such as subsidized inputs (energy) or tax exemptions. For example, based on Schiffbauer and others (2015), only 8 percent of all firms but 45 percent of connected ones operate in energy intensive sectors. This has led to a suboptimal allocation of production factors and government resources to energy intense sectors to the detriment of labor intensive activities.

Perceptions of corruption may have constrained private sector’s development. Perceptions-based corruption indices show high levels of perceived corruption in Egypt compared to most regional peers and other emerging market economies. The perception of corruption is likely to have discouraged domestic investment and constrained growth, in light of findings in the literature. About 70 percent of firms surveyed in the 2016 WBES identify corruption as a major constraint up from about 50 percent in 2013.

Access to finance is low in Egypt and limits firms’ development. Based on 2016 WBES, only about 12 percent of surveyed Egyptian firms have a bank loan or a line of credit and use banks to finance working capital. About 25 percent of Egyptian firms surveyed in the 2016 WBES report access to finance as a major obstacle compared to about 30 percent in 2013. Indeed, credit to the private sector is low in Egypt, at 34 percent of GDP. Historically, the banking sector has concentrated its lending to the government, and private sector credit is mostly directed to a few large firms.

Transport infrastructure compares well with peers but connectivity could be improved. Egypt ranks in line or above EM peers on the quality of infrastructure on the Global Competitiveness Index. However, additional investment is needed to further improve transport infrastructure and ensure a good connectivity between ports, airports and markets through well connected roads and railroads networks. The Global Infrastructure Outlook (G20 Initiative) estimates Egypt’s cumulated investment gap in transport infrastructure over the next 10 years at USD 70 billion, about 27 percent of current GDP. The lack of an integrated strategy for multi-modal transport logistics have constrained investment and increased the domestic cost of transporting products to markets. Despite important needs and potential, FDI in transport infrastructure and agribusiness logistics (e.g., storage facilities) has been limited by the lack of an integrated strategic and regulatory framework.

Engaging in international trade has been constrained by regulatory bottlenecks and the erosion of external competitiveness. Prior to the float of the currency, the appreciation of the Egyptian pound in real terms weighed on Egypt’s external competitiveness. In addition, regulatory bottleneck and barriers to trade have made private sector-led trade integration more difficult. Egypt scores 42 over 100 on the distance to frontier indicator for trading across borders in the World Bank Doing Business. Custom procedures are lengthy, and are perceived to lack predictability, which impacts negatively on the time and cost of exporting and importing. Egypt scores 3.7 over 7 in the World Competitiveness sub-index on burden of custom procedures. Nonetheless, some progress has been achieved in recent years. Based on the 2016 WBES, it now takes 14 days to obtain an import license, down from 20 days in the 2013 WBES. While tariffs barriers were reduced significantly in the 2000s, non-tariffs barriers remain widespread. Based on WTO data, Egypt has 274 non-tariff measures, primarily technical barriers to trade and sanitary and phytosanitary measures. All this contributed to limit FDI and trade and thus the productivity gains that could have been derived from deeper integration.

Policies to Foster a Dynamic and Productive Private Sector

The Egyptian authorities’ reform program aims to foster private sector-led growth and job creation. To achieve this, Egypt needs to increasingly shift its economic model towards more private sector participation and integration into global value chains. It needs to promote the emergence of a pool of young and dynamic firms that create jobs, invest, and raise productivity.

Recent progress in restoring macro-stability present an opportunity for higher private sector investment and growth. Over the last few years, the Egyptian authorities have engaged in an ambitious reform program aimed at restoring macro-stability, improving external competitiveness and promoting private-sector led growth and job creation. On the fiscal side, they are moving ahead with a consolidation program based on rationalizing and re-prioritizing expenditures and raising revenues. They have implemented the civil service law which aims to contain the public sector wage bill, hiked energy prices to gradually eliminate the energy subsidy bill and started to improve the targeting and quality of social spending. They have also implemented the value-added tax with a broader coverage and a higher rate than the previous sales tax. On the monetary and exchange rate side, the Central Bank has liberalized the exchange rate, eliminating FX shortages and the overvaluation of the pound, which had been identified as a major constraint on the economy’s competitiveness in the past, and it has rebuilt its foreign exchange reserves. All of this has contributed to restore market confidence and ongoing reforms are starting to bear fruit. GDP growth rebounded to 5 percent in Q4 of 2016/17 and there are signs of a rebalancing of growth from consumption to net exports. The fiscal deficit has started to narrow and public debt is expected to start declining in the coming years. Thanks to adequate monetary tightening, inflation has also started to slowdown.

The authorities are taking steps to streamline the role of the state in the economy and improve governance. They have started to implement reforms in specific sectors, notably by creating independent regulators. Key steps have been taken in the energy sector and initiatives are ongoing in the health sector and are planned in the transportation sector. The authorities are also planning to publish a report on state-owned enterprises, including their financial performance, activities, ownership, organizational structure and audited reports to improve SOEs’ governance, transparency and accountability. They are also planning to divest stakes in 5 to 6 public entities over the next two years to improve governance and financial management and promote private sector’s participation in some economic activities.

Structural reforms recently implemented by the authorities to improve the business environment are encouraging. The authorities have already taken steps to reform the regulatory framework to improve the business environment. They have enacted a new industrial licensing law which aims at easing the time and cost of starting a business. It reduces the number of entities involved and the number of procedures required to obtain licenses to operate businesses. These reforms are starting to bear fruit and the number of newly established companies increased by 36 percent year-on-year over January-August. They are also planning to take measures to streamline import and export requirements. Some measures have also been taken to improve access to land, including centralizing the allocation and management of land allocation under one entity. As a result, the government has granted close to 70 percent more industrial land in 2016/17 than over the previous 8 years. The authorities have also revised the Investment law to strengthen the protection framework for investors and streamline processes and they are planning to revise the Insolvency and Procurement laws next year. They are also taking measures to support SMEs, including the revision of the Companies law (to include single person companies) and measures to foster financial inclusion.

However, more is needed to achieve higher sustainable growth rates and generate jobs in the private sector. Reforms should aim at providing a stable, predictable and fairly implemented regulatory environment conducive to private sector activity, removing bottlenecks to higher private sector investment, notably in terms of access to finance and land, promoting domestic connectivity and integration into global value chains. With restored macroeconomic stability and the adequate structural reforms, Egypt has the potential to attract much higher FDI and develop private sector activity in the tradable sector to achieve higher job creation and investment, improve productivity and raise potential growth. Reforms should be directed at:

• Providing an adequate and stable regulatory regime that guarantees a level playing field for all business participants. The authorities should build on reforms that are already in progress and ensure that additional regulatory changes are in line with international best practices, notably the Insolvency and Procurement Laws which are in the process of being revised. The authorities also need to ensure that legislative reforms aimed at creating a level playing field are adequately implemented and do not suffer from capture by specific interest groups. For this, the executive regulations associated with legislative changes should be clear and transparent. Better coordination among different state entities, headed by a dedicated unit, would help improve the consistency and efficiency of governments’ policy implementation. Additional reforms could aim at strengthening competition, notably by strengthening the role of the Egyptian Competition Authority (ECA).

• Improving institutions and governance. Important steps to reduce corruption could include reforms to build greater capacity and accountability in the public administration and improve transparency and information to all citizens. In all economic sectors, setting up independent regulators would reduce the scope for corruption and unequal treatment between public and private sector operators. In addition, more needs to be done to improve SOEs and other public entities’ governance to reduce the distortions between public and connected firms and other private sector firms, improve transparency vis-à-vis citizens, level the playing field by providing transparent information to private sector participants on market opportunities and SOEs’ activities, and improve SOEs’ financial viability.

• Removing constraints to higher investment by the private sector, notably regarding access to finance and access to land. Regarding access to finance, fiscal consolidation will generate space for higher private sector credit. Large public sector deficits have crowded out an important share of bank financing that could otherwise have gone to productive private firms. The authorities reform program should contribute to generating space for bank lending for higher private sector investment. In addition, strengthening credit bureaus and collateral registry systems would help include small firms that lack access to finance. Regarding access to land, clarifying land ownership between different state entities would help simplify access. Land allocation could also benefit from a more open and competitive process. Competitive bidding processes and publication of land sales and the use of the proceeds would improve transparency, reduce distortions and generate more revenues for the state. Simplifying property registration could also help stimulate investment and the use of property as a collateral.

• Developing better connectivity to improve products market efficiency. Fiscal consolidation and the reorientation of public spending away from generalized subsidy will free up space for higher public investment. In this context, it will be important for Egypt to have a sound framework in place for the prioritization, selection and appraisal of public investment projects. It should also develop an integral long term public investment strategy to improve Egypt’s domestic and international connectivity and create a favorable environment for the private sector that reduces transaction costs and foster access to new markets. To promote private sector investment in infrastructures and logistics, Egypt also needs to develop a sound supervisory framework for overall connectivity infrastructure.

• Promoting trade integration. The transition to a flexible exchange rate regime and a monetary framework focused on controlling inflation will help preserve external competitiveness and offers opportunities for higher trade integration. In addition, other measures, to strengthen the benefits of integration into global value chains should include removing legal barriers to FDI and trade barriers (including non-tariff measures).

At a time when Egypt is implementing policies to promote private sector’s growth and job creation, targeted policies can help ensure that youth and women are not excluded from these new employment opportunities. Policies should be directed at improving the functioning of the labor market and ensure that Egyptians entering the labor force are equipped with the skills needed by employers and that women face equal opportunities to take on jobs.